In a highly anticipated decision last week, the U.S. Court of Appeals for the
2nd Circuit unanimously affirmed the Southern District of New York’s dismissal
of South Cherry, LLC’s breach of contract and securities fraud claims against
the investment advisor Hennessee Group LLC for losses sustained as a result of
Hennessee’s recommendation to invest in the Bayou Hedge Fund Group.

The hedge fund turned out to be a Ponzi scheme, and South Cherry lost much of
its investment. This decision has important
implications for claims being made against feeder funds and investment advisors
for putting their clients’ money in Bernard L. Madoff Investment Securities LLC. South Cherry Street LLC v. Hennessee Group LLC,
07-3658-cv (2nd Circuit, July 14, 2009).

Hennessee promoted itself as the “industry leader” and the most recognized
hedge fund consulting firm in the industry. In its presentation to South Cherry,
Hennessee boasted, among other things, that it had “direct relationships with
hedge funds” and reviewed “550 [funds] per month” with its “proprietary database
and analytics” and a five-phase “unique due diligence process.” It claimed to
consider only “hedge funds with 3 years audited track record” and checked the
hedge fund personnel, cash positions, prime banking relationships and other such
critical data.

Based on the presentation, South Cherry alleges that it entered into an “oral
contract” with Hennessee to recommend hedge fund investments for a fee based on
a percentage of the investment. One such recommendation on which South Cherry
relied was Bayou Accredited, part of the Bayou group run by Samuel Israel and
Daniel Marino.

The Bayou Hedge Fund Ponzi scheme is well-documented elsewhere, and looks a
lot like the Madoff scheme. Bayou’s principals diverted moneys from the funds
for personal use, and essentially stopped trading in 2003. Arrearages were
covered by later investments into the fund. Early on in the scheme, Bayou fired
its independent auditors and retained a firm of auditors that was actually owned
by Marino, a Bayou insider, that did not issue genuine audited reports. The
Bayou Funds liquidated in 2005, with no returns to any of its investors. The
principals later pled guilty to securities fraud charges.

South Cherry sued Hennessee claiming it breached its oral agreement to
conduct thorough due diligence as promised, and for securities fraud. Hennessee
moved to dismiss on two grounds: (1) the alleged oral contract was unenforceable
because of the statute of frauds; and (2) South Cherry failed to adequately
allege with particularity actual or reckless behavior to satisfy the pleading
requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA).
The district court agreed and the appeal ensued.

The 2nd Circuit, in a unanimous affirmance written by Judge Kearse, agreed
that the oral agreement was not enforceable, because it was not to be performed
within one year and thus voidable under the New York statute of frauds. As a
result, the due diligence and other representation made by Hennessee were not
contractually enforceable.

The court also took a dim view of South Cherry’s securities fraud claims
under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5,
because the plaintiff could not meet the PSLRA’s heightened pleading
requirements. Section 21D(b)(2) of the act states in relevant part:

“in any private action arising under this chapter . . . the complaint
shall . . . state with particularity facts giving rise to a strong inference
that the defendant acted with the required state of mind.”

The court held, as have other courts, that in the absence of a showing of
actual fraud, to prove scienter, a plaintiff must make a “strong showing of
reckless disregard for the truth,” meaning a “conscious recklessness – a state
of mind approximating actual intent, and not merely a heightened form of
negligence.”

In the securities fraud context, the plaintiff must allege specific conduct
that “at the least [is]highly unreasonable and which represents an extreme
departure from the standards of ordinary care to the extent that the danger was
either known to the defendant or so obvious that the defendant must have been
aware of it.” Or that defendants “failed to review or check information that
they had a duty to monitor, or ignored obvious signs of fraud,” and hence
“should have known that they were misrepresenting material facts.”

Applying these principles to this case, the court found that the complaint
failed to allege scienter with sufficient particularity to meet the heightened
requirements of the PSLRA. Since there was no enforceable contract, South Cherry
was left to allege either actual fraud or some form of especially egregiously
reckless behavior tantamount to a knowing disregard of the consequences for the
defendants’ actions. South Cherry’s allegations of failure to exercise promised,
or even appropriate, due diligence did not meet that threshold.

The significance of this case for those suing the feeder funds and investment
managers who placed assets with Madoff is that the securities laws may not
provide a remedy – allegations that the advisor “should have known” that Madoff
was a fraud is not enough under the PSLRA. A plaintiff must allege specific
facts showing that the defendants actually knew of the fraud, consciously
disregarded adverse information, or engaged in other reckless conduct when
making investments or giving recommendations.

However, South Cherry does not resolve what is likely to be a real
battleground in the cases against the feeder funds and investment advisers – the
scope of defendants’ contractual obligations (and in some cases, their fiduciary
obligations) to their clients in which less stringent non-PSLRA pleading
requirements will be applicable.

In fact, most complaints in these cases have paid considerable attention to
the contractual obligations based on written agreements, the feeder fund
offering memoranda and marketing materials. Plaintiffs argue the funds failed to
diversify investments as promised, failed to reveal that Madoff was the
investment vehicle for a significant portion of their portfolios, or failed to
exercise the promised levels of due diligence before recommending or investing
in Madoff and his firm. A likely defense is that the defendants were duped, too,
like the SEC, and that further due diligence within the limits of the possible
would not have uncovered the fraud.

Whether these traditional common law claims based on state law and not
federal securities acts will protect duped investors, remains to be seen.